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Optimal convergence trading with unobservable pricing errors

Author

Listed:
  • Sühan Altay

    (WU-University of Economics and Business)

  • Katia Colaneri

    (University of Rome Tor Vergata)

  • Zehra Eksi

    (WU-University of Economics and Business)

Abstract

We study a dynamic portfolio optimization problem related to convergence trading, which is an investment strategy that exploits temporary mispricing by simultaneously buying relatively underpriced assets and selling short relatively overpriced ones with the expectation that their prices converge in the future. We build on the model of Liu and Timmermann (Rev Financ Stud 26(4):1048–1086, 2013) and extend it by incorporating unobservable Markov-modulated pricing errors into the price dynamics of two co-integrated assets. We characterize the optimal portfolio strategies in full and partial information settings under the assumption of unrestricted and beta-neutral strategies. By using the innovations approach, we provide the filtering equation which is essential for solving the optimization problem under partial information. Finally, in order to illustrate the model capabilities, we provide an example with a two-state Markov chain.

Suggested Citation

  • Sühan Altay & Katia Colaneri & Zehra Eksi, 2021. "Optimal convergence trading with unobservable pricing errors," Annals of Operations Research, Springer, vol. 299(1), pages 133-161, April.
    • Handle: RePEc:spr:annopr:v:299:y:2021:i:1:d:10.1007_s10479-020-03647-z
    DOI: 10.1007/s10479-020-03647-z
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    References listed on IDEAS

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